Seats at the Chicago Board Options Exchange are on a perennial upward climb these days. Each week, it seems, the CBOE announces a new record for the price of a seat, shattering the previous one. This has become such a regular occurrence that it’s hard to believe it wasn’t always the case.
Back in the late 1990s, the CBOE was in a comparable position to today concerning seat prices. The stock market was trading at lofty heights, and everyone wanted to be involved in the options business.
While equity analysts were obsessing over microprocessors and memory chips, obscene fortunes were being made-and lost-in the CBOE’s trading pits. The incredible demand to trade options translated into a remarkable run-up in seat prices. This bull market for seats culminated in February 1998, with a then-record price of $735,000.
Heading To Zero
Long before the tech boom went bust, the bloom began to fade from the CBOE’s rose. The rise of electronic trading, along with the dawn of multiple listing, combined for a lethal one-two punch to the CBOE’s seat prices.
Although options volume remained strong after 1998, it was definitely an unsettling time to be a member of the CBOE. Competition from the International Securities Exchange loomed on the horizon. Compared with electronic trading, traditional open outcry seemed slow, inefficient and costly. Why bother leasing, staffing and maintaining an expensive trading floor when a few servers and an IT team could accomplish the same task?
With its market share eroding, CBOE members began making markets on how long the exchange would survive. Needless to say, bids greater than one year were difficult to find. It was during this dark period that seat prices hit their low of $150,000 in August 2002. At the time, even that price point seemed overvalued and a gamble. With the growing prominence of electronic trading, CBOE seats appeared to be on a one-way trip to zero.
CBOE seat prices finally bounced back in late 2002. This resurgence coincided with one of the seminal events in the derivatives world-the Chicago Mercantile Exchange (CME) IPO.
The launch of CME stock in December 2002, and the massive run-up that followed, awakened Wall Street to the enormous potential of the derivatives sector. A market that most considered mysterious and arcane had suddenly become the darling of analysts and investment bankers.
The success of the CME IPO inevitably led to speculation about which derivatives exchange was next. As the overall leader in options volume, it wasn’t long before attention turned to the CBOE. Oddly enough, the same people who had earlier dismissed the exchange as a dinosaur were now eagerly speculating on the date of its IPO.
SPX Lifeline
Of course, other developments helped to boost the value of CBOE seats. The launch of the exchange’s Hybrid trading system, along with an increasingly aggressive payment-for-order-flow program, finally managed to stem the CBOE’s hemorrhaging market share.
In an industry rife with identical products, the CBOE also had one advantage over its competitors-monopoly products. Thanks to its stranglehold on the lucrative SPX product line, the CBOE was able to remain the top options exchange.
While the CBOE’s piece of the options market may have shrunk on a percentage basis, overall options volume was expanding. This rising options tide lifted every exchange, including the CBOE, to record volume and profit levels.
At the beginning of 2005, the CBOE’s seats had nearly doubled in value, to $299,000. By the end of the year, they had rallied to an impressive $875,000-an astounding 293 percent jump in a year.
As the options market continued to explode, so did the price of a CBOE seat, passing the $1 million mark for the first time in February 2006. By the end of the year, a seat traded at an incredible $1.75 million.
Many analysts assumed that CBOE seats had finally hit their peak in 2006. The value of membership on the exchange had increased by nearly twelvefold since the dark days of 2002. By any rational measure, they were beginning to look overvalued.
However, exploding options volume and continued IPO speculation drove the seats even higher in 2007. So far this year, CBOE seats have rallied an impressive 54 percent to $2.7 million.
The Exercise
Despite this good fortune, the sword of Damocles is hanging over the heads of CBOE seat owners in the form of the Chicago Board of Trade exercise right. For most of its history, the exercise right was viewed merely as a convenience for CBOT shareholders. However, with a multi-billion-dollar IPO on the horizon, that convenience has ballooned into a serious potential liability for the CBOE.
The newly formed CME Group has pledged to “vigorously defend” its members’ rights to “share equally in any CBOE demutualization.” Essentially, the CME wants exercise-right holders to be treated as full members of the CBOE. The outcome of this dispute remains uncertain pending a decision by the Delaware Court of Chancery. However, if the CME gets its way, it would be a disaster for current CBOE seat holders.
With fewer than 1,000 members on the CBOE’s rolls, and more than 800 exercise-rights holders in CME Group (and potentially more on the horizon), the CME plan could effectively double the number of ownership stakes in the exchange. In such a scenario, the current seat price of $2.7 million could conceivably be cut in half.
As if the exercise right wasn’t enough for seat holders to worry about, there is another sign that the CBOE may not be as healthy as it appears. When seats reached their high of $735,000 in 1998, the value of seat leases also exploded. Demand to become an exchange member was so strong that traders eagerly waited several months for the privilege of paying $12,000 to $15,000 per month to lease a seat.
Unfortunately, most of that demand has since evaporated. Although seats have appreciated nearly 370 percent in the intervening years, seat leases are now trading at a mere fraction of their highs.Part of this decrease can be traced to the CBOE’s decoupling of lease prices from seat prices in 2005. However, even with these drastically reduced lease prices, the days of traders lining up for the chance to trade on the CBOE are long gone.
Membership’s Privilege
While plunging lease prices may not concern speculators looking to profit on a CBOE IPO, the drop speaks to an underlying problem at the core of the exchange. Seat leases are the ultimate measure of the long-term viability of any exchange. Membership used to have its privileges, including early access to information and two-sided order flow. With today’s exchanges functioning as little more than crossing platforms, and so much price discovery taking place off the floor, there is little value to membership.
The fact that so few traders are willing to pay even a few thousand dollars to lease a seat speaks volumes about the changing nature of today’s options market. Speculators may be giddy over the future of the CBOE, but those who make their living on the exchange are singing a very different tune.
Mark S. Longo, a longtime contributor to Traders Magazine, is the founder of The Options Insider (www.TheOptionsInsider.com), which covers the options markets with news, analysis and podcasts.
